Three rules:
1. Give first, and you can take later.
2. Take first, and you must give later.
3. To get started, someone must take first. (There's nothing bad in taking first.)

Wednesday, November 30, 2016

A Bank "Loan" Is An Overdraft; It Is Not a Loan

Nice title, huh? I'll try to explain.

Many people have argued that a "bank loan" is not really a loan, because the bank is not lending any existing money; it creates the money it "lends" on the "borrower's" account and the money is destroyed when the loan is repaid. Still, from the bank customer's perspective, it looks like a loan: he receives money on his account ("from the bank"), spends the money and has to get the (same sum of) money back on his account to be able to return it ("to the bank") when the loan becomes due.

Not so in the case of an overdraft.

By agreeing[1] with his bank on an overdraft facility (a "credit line") connected to his checking account, the customer can spend money he doesn't have[2]. The customer incurs debt by using the overdraft – in the textbook case – to purchase goods[3] and repays that debt by selling goods.

I cannot stop people imagining that there was money first borrowed and later returned in the case of an overdraft, too. One can describe an overdraft in terms of what I call a "traditional bank loan".

What I want to argue here is that this works the other way, too; that one can describe a traditional bank loan in terms of an overdraft. Furthermore, I argue that we can consider an overdraft – I'm talking about the accounting treatment – as the "base case" and view the accounting treatment of a traditional bank loan as an unnecessary complication. (If this sounds unnecessarily provocative, take it as an argument against any kind of primacy, other than chronological/historical, given to the traditional bank loan. An overdraft doesn't involve "netting" something more than a traditional bank loan involves "grossing" something.)

Imagine that the accounting treatment of all kinds of debt had always been like it is in a case of an overdraft. (Perhaps it's just a historical accident that it hasn't been?) The credit contract – which should be viewed separately from the accounting treatment – could state that the overdraft limit is to be reduced monthly by a certain sum and that the limit will reach zero in, say, 10 years (for a 10-year "loan"). The contract would also state when interest is paid (through a debit entry on the checking account, as usual).

To help you imagine that kind of world, I have created a document where I map the corresponding figures in the two alternative accounting treatments. The color of the circle tells which figures correspond. (Please note that where I write "Unused overdraft" it should actually say "Unused
ovedraft + initial checking account balance". In that way it would also
cover the most common scenarios where the initial balance is not zero but
positive.)

Had the accounting treatment always been that of an overdraft, not of a traditional loan, the wordsand concepts we use might differ from what they are today.

For instance, we would repay debt when we sell goods (item #3 in my document), not when the overdraft/credit limit is reduced (item #4). The latter is how we see repayment when we think of a traditional loan. If the accounting treatments are identical in their outcome, then why this discrepancy?

As far as I know, this discrepancy is one of the main reasons why Nick Rowe thinks an overdraft is "negative money" while a traditional bank loan isn't. Another reason perhaps has to do with the maturity of the credit limit, but that is something which is specified in the credit contract, regardless of the accounting treatment. There are bank loans without any clear, pre-agreed maturity, just like there are overdrafts with a pre-agreed maturity. And even if the maturity is specified in the contract, there is nearly always a lot of flexibility involved – after all, it is quite often in the bank's interest that a customer repays his debt more slowly.

If we had never seen a "traditional bank loan", would we talk about the bank lending us money, or would we only talk about the bank extending credit to us? Would we still think that there is money on our account, and that we need that money to pay for things? Or would we just talk about "the number" on our account?

The world of overdrafts looks quite different from the world of traditional bank loans – at least to me and, so I've understood, Nick Rowe. If you don't see the difference, it might be because you try, quite successfully, to interpret overdrafts in terms of traditional bank loans. (Or then you're JKH, who is probably comfortable in both worlds.)

[1] I'm talking about a pre-authorized overdraft, which is in practice more common in Europe than in the US. One can also "overdraw" one's checking account without any prior agreement with the bank, but in that case there will usually be penalty charges.

[2] Alternatively, we could say that the unused overdraft is money he has, although it doesn't reside on his account – and never will.

Keynes (“A Treatise on Money”, Bk 1, Ch 3, 8ii(i.) “Deposits and Overdrafts”) was of the opinion that unused overdrafts should, logically, be included in monetary aggregates:

... it is the total of the cash-deposits and the unused overdraft facilities outstanding which together make up the total of Cash Facilities. Properly speaking, unused overdraft facilities – since they represent a liability of the bank – ought, in the same way as acceptances, to appear on both sides of the account. But at present this is not so, with the result that there exists in unused overdraft facilities a form of Bank-Money of growing importance, of which we have no statistical record whatever, whether as regards the absolute aggregate amount of it or as regards the fluctuations in this amount from time to time.

Thus the Cash Facilities, which are truly cash for the purposes of the Theory of the Value of Money, by no means correspond to the Bank Deposits which are published.

I see that we have two options if we want to be logical: either unused overdrafts are money, too, or then "cash-deposits" are not money, either. I opt for the latter, not least because there is only a fine line between a pre-agreed unused overdraft and an overdraft – or a "traditional bank loan" for that matter – that the bank would be willing to provide if only the customer wanted it. Trying to find out the size of Keynes' "Cash Facilities" is much like trying to find out the total amount of purchasing power in the economy – a hopeless task, if you ask me.

[3] He could be buying and selling financial assets, but it's best to leave that alternative out of scope for now. The interpretation of that case is somewhat more complicated within the broader framework/theory I'm promoting in my posts. One day I'll get back to that.

72 comments:

I think the problem is the definition of the word loan. In Nick's past blogs it is never quite clear whether he means a loan of an existing thing (by whom to whom?) or the creation of a new thing. In the case of the often quoted 'loans create deposits' for example, we are clearly dealing with the creation of a new thing. Furthermore, when a loan is created ex nihilo, as is also the case with an overdraft, it constitutes the creation of a new hierarchy level within the system. The overnight market for reserves is a market of bilateral loans in the traditional sense whereas the extension of credit to borrowers by banks is using the word loan in the same sense as you define an overdraft. Whether the concept of a loan is an unnecessary complication of the underling truth or whether the concept of an overdraft is an illegitimate simplification of it, is another discussion.

We can take position of an outside observer who views the complete overdraft transaction. Here is what I think he observes:

1. A seller somewhere who receives green money.

2. A bank overdraft customer who spends more green money than is in his account.

3. A bank who delivers green money from funds NOT IN THE CUSTOMERS ACCOUNT. (A third party must have delivered green money).

I think your argument (in this post) is that the bank itself is not delivering green money. More exactly, green money is actually red money. In this, you would be agreeing with Sinn who argued that TARGET2 positive balances are debts-at-risk.

Here is a method of showing both points simultaneously: Assume that money represents labor. Assume further that labor must be performed before money is created. We have now assumed that all money represents labor performed.

Now we want to loan money. Can we loan labor performed in the past? No. We can only lend labor to be performed IN THE FUTURE.

So what is money if we stick with these assumptions? More difficult, what is money when the lender has no MONEY-OF-HIS-OWN to loan but makes the loan anyway?

It seems to me that these last two questions need to be answered. Would you agree?

I don't actually care about how people define 'loan'. Of course it can be defined to mean whatever we want, but the word has "baggage" and its use is problematic if it isn't connected to the conventional meaning of the word. For instance, some economists would probably tell that it is really a LOAN of goods (between a non-bank borrower and a non-bank lender) we are talking about when we talk about a "bank loan"; this is the "loanable funds" concept.

Do you see anything problematic in the discrepancy I pointed to? About how we define "debt repayment"?

Overnight market for reserves is just like the "loan market" between non-banks. And when it comes to reserves, the banks always have the alternative to ask for credit from the central bank, in which case they get reserves that are created 'ex nihilo'.

I don't really know what 'ex nihilo' even means in this case (it's not only you who uses it). Of course it is created 'ex nihilo', like all accounting entries are. If you look at how the central bank in my third post recorded Betty's gift given and Andy's gift taken -- how else could those records be created than 'ex nihilo'?

Not necessarily. The seller might have had an overdraft, in which case he doesn't receive any money. He got rid of (some of) his liability ("red money") by selling goods.

Roger said: "3. A bank who delivers green money from funds NOT IN THE CUSTOMERS ACCOUNT. (A third party must have delivered green money)."

No party needs to deliver green money. The bank makes a credit entry on the seller's account, and that's it. There is no money leaving the buyer's account and no money arriving at the seller's account. (Try to get your head around that... It took me at least one year of full-time brain torture to arrive at that conclusion.)

I see that you are still thinking like Marx :-) I don't think the way you try to connect money with labor is fruitful. But perhaps I just miss your point.

I know it's the other discussion you're interested in and I mostly agree in substance, although maybe not fully in the way you frame it. Just thought I'd make a point that was orthogonal to your's but fits in nicely with your post and Nick's.

I am surprised that my examples frequently fail to resonate with you. What I see as obvious, you completely fail to see, for reasons unclear to me :-)

My first thought is that you don't take time to absorb the complete illustration. For example, you did not absorb that the seller had received green money. Then you jumped to a new posibility, offering that the seller may have had a debt that could have been paired with my assumed three-way exchange.

Having missed the first green money receipt, you can be forgiven for missing that the bank must have transferred green money.

You are a great writer, writing with a lot of insight. That is why I like to read your work. But I do find it hard to present examples we can both embrace :-)

I apologize. I didn't read your comment carefully enough. Now that I did, I wouldn't have answered like I did, but I'm still struggling with getting your point :-)

You meant that your observer offers different interpretation from mine? And you want to combine these two interpretations (you talk about "points", though)?

I think it would help if we are careful in separating phenomena from our interpretation of it. Look at this sentence:

"No party needs to deliver green money. The bank makes a credit entry on the seller's account, and that's it."

The credit entry is the phenomenon. And you interpret it as someone delivering/transferring green money. Or is there some other phenomenon you talk about when you say that "the bank must have transferred green money"?

So you're not sure what Nick means when he talks about a 'loan'? As far as I know, his 'loan' can be both a loan of an existing "thing" and a "traditional bank loan" as I define it in the post. When Nick talks about ovedrafts, he stresses the fact that one doesn't need to receive green money to get rid of the liability, as one does in the case of a traditional bank loan.

I just have a feeling that the commenters on his blog used it in both ways, often interchangeably, which confuses things further. Also, I'm not sure Nick wants to use the distinction - probably for some reason. One can sell goods or assets to reduce one's overdraft. It's a question of accounting formalities whether one records that in two steps (green money in, then red money out) or in one step. My only point, if any, is that formalities matter, they have a life and a meaning of their own. So, even if it's the accountant's ultimate goal to become indistinguishable from that which is being counted, the realist in me (or is it the idealist?) tells me that will never happen. So we need to study the discrepancies. Back to idealising though, I think we both can agree that if a monetary economy is delayed barter, then the delay = money?

(A) In your accounting example I noticed you're equating the accepted but undrawn overdraft with a granted and booked traditional loan in item # 1. However, couldn't we also equate the granting of an overdraft, not yet drawn, with a situation where the bank promises to lend up to a certain sum if and when the customer chooses to accept the offer? (At least that happened to me a few years back regarding a potential mortgage.) Hence, in item # 2, there would be equality between a drawn overdraft and a booked loan. That would also be the first time off-balance-sheet obligations become on-balance¬-sheet items. Although that would "un-synchronize" the buying/selling time sequences in your example.

This point of view pertains to the question about whether drawn or undrawn overdraft should be the main focus in the analysis. Which, in turn, depends on whether (or to what degree) we should consider undrawn overdrafts to be binding obligations? Usually the banks retain discretion to alter or withdraw such commitments if necessary – say, if the overall credit situation in the market or for the customer deteriorates.

(B) Regarding the "discrepancy". I'm not entirely sure there is one. When I look into the mirror and move my right arm it looks like I'm moving the left. The reduction of the credit limit may or may not be equated with "repaying" a tradition loan. As implied in (A), such reduction (or suspension) of the overdraft credit limit could simply be implemented if the credit situation deteriorates. And in that case, it should not be equated with a "repayment" of a loan.

What, from the point of view of an overdraft, still can be equated in terms of repayment – the mirror image of reducing the customer's liabilities to the bank – is if we consider the customer acquiring claims vis-à-vis the bank. That claim may simply be a legal title (it doesn't matter). The relevant issue is that such claim is only booked differently depending on whether we're using overdraft accounting or a combined loan- and checking account accounting.

In a way, simply using the definition for overdrafts like the Bank of England: "Overdrafts are defined here as debit balances on accounts which, if in credit, would be classified as deposits." … Even in an overdraft-only world, there could still be "positive balances" which could be defined as "deposits", which could be used as analytical tools in explaining changes to overdrafts in terms of incurring/acquiring liabilities/claims vis-à-vis the bank.

Back home with my familiar computer. Nice after trying to reply with the tablet!

I've been thinking as I traveled. Too many thoughts can just confuse things so I will expand on only one:

You wrote "No party needs to deliver green money. The bank makes a credit entry on the seller's account, and that's it." I hope I correctly understood that statement to mean that when a borrower spends into the hands of a seller, that is the end of the phenomenon. Correct?

I got to thinking that definition sets up the answer by ignoring further transfers by the seller. In other words, a one time, limited event can preclude other realistic and likely events.

I got to thinking that instead of a single seller, the single seller is the first in a chain/sequence of sellers. If we have the beginning of a chain of sellers, any one of the subsequent sellers has the option of delaying monetary transfer for long periods, converting the credit entry to green cash, transferring the credit entry out of region (which would be like savings) or even actually destroying the credit entry by converting the credit to cash and then suffering a catastrophic fire.

Several of these possible events would render repayment by the borrower very difficult or even impossible (if we limited repayment to the exact money received on credit). This can be contrasted with a pure single-seller-credit-event where the borrower could certainly receive the exact borrowed credit back if only the borrower could directly interact with the seller.

To recap, the first seller and all subsequent sellers have an option to treat payment as a physical, real object. This makes a theory that depends upon both borrower and seller having an account at the same bank--very limited in scope and not likely to be representative of the real world.

Does this make sense to you? Maybe I am just suffering from "car-daze" :-)

I don't ignore the possibility that the initial seller is a buyer later on, after finding another seller. And what I say is not restricted to one bank, although I like to simplify things by talking "as if" there was only one bank (which can be taken to represent the banking system as a whole). Anything that happens between banks is not visible to the buyer and the seller; for them, it's all about the debit and credit entries which change the balances on their checking accounts -- and that's what I focus on.

Johan: Thanks for the thoughtful comment! I'm not sure if I understood all your points. Let's see.

Regarding A:

You said: "However, couldn't we also equate the granting of an overdraft, not yet drawn, with a situation where the bank promises to lend up to a certain sum if and when the customer chooses to accept the offer?"

You almost convinced me, but I have to say no, we can't.

The offer by the bank could as well be related to an overdraft limit. It's one-sided, whereas a pre-agreed overdraft is based on a credit contract (just like in the case of a "loan") signed by both parties.

What you suggest is closely related to the point I made in footnote 2:

"I see that we have two options if we want to be logical: either unused overdrafts are money, too, or then "cash-deposits" are not money, either. I opt for the latter, not least because there is only a fine line between a pre-agreed unused overdraft and an overdraft – or a "traditional bank loan" for that matter – that the bank would be willing to provide if only the customer wanted it."

You said: "Hence, in item # 2, there would be equality between a drawn overdraft and a booked loan."

How do you see that as an equality? There wouldn't be equality in my sense of the word, because neither the figures in yellow circles nor the figures in green circles would match.

You said: "...whether (or to what degree) we should consider undrawn overdrafts to be binding obligations? Usually the banks retain discretion to alter or withdraw such commitments if necessary – say, if the overall credit situation in the market or for the customer deteriorates."

Here, as in some other places in your comment, you are discussing overdrafts in a broader sense, in practice (as they are used in the real world), not just as an alternative way to do the accounting. What you talk about is a matter related to the credit contract. As I wrote in the post:

"Another reason perhaps has to do with the maturity of the credit limit, but that is something which is specified in the credit contract, regardless of the accounting treatment. There are bank loans without any clear, pre-agreed maturity, just like there are overdrafts with a pre-agreed maturity. And even if the maturity is specified in the contract, there is nearly always a lot of flexibility involved – after all, it is quite often in the bank's interest that a customer repays his debt more slowly."

A bank can try to withdraw a credit line (overdraft) -- should the credit contract allow it -- but is only successful in it if the customer is able to bring his balance back to zero. If the balance is already zero when the bank withdraws the credit line, that is comparable to a bank forcing a "repayment of a loan" -- again, should the credit contract allow it -- on a customer whose checking account balance covers the balance on his loan account.

I think I have covered above already most of the points you made in B, too, and you said that you had mis-read me, so I won't continue. But let me know if I didn't address all your points?

Oliver said: "Back to idealising though, I think we both can agree that if a monetary economy is delayed barter, then the delay = money?"

This sounds like something I can agree on. With the usual disclaimer that you and I might know what it is exactly that we agree on (no 100% certainty, though), but for others that might not be explicit enough, at all. That's why I think it's best for me to continue building the system from where I left it after Betty gave bananas to Andy.

The following part of your comment was slightly too cryptic for me, but it sounds interesting, so I'd appreciate if you could try to elaborate it (it seems you have overestimated my intellect; perhaps because I accidentally happened to know about Magritte's pipe?):

"My only point, if any, is that formalities matter, they have a life and a meaning of their own. So, even if it's the accountant's ultimate goal to become indistinguishable from that which is being counted, the realist in me (or is it the idealist?) tells me that will never happen. So we need to study the discrepancies."

By the way, I did notice that it was you who originally used the word "epiphany" in Nick's blog (JKH only commented on it), and I assumed it was directed at me. I'm willing to go to great lengths to show you that I'm not, in the end, talking about an imaginary world ;-)

Antti, the equality I suggested simply refers to comparisons either being off-balance sheet items or on-balace sheet items. I read your example as starting with a potentially incongruous comparison (in terms of a potential real world setting). A drawn overdraft has a closer "matching" with a booked loan than an undrawn overdraft agreement in this regard.

When you ask "Roger: What is "green money" for you? Only high-powered money?", you are asking a great question. It is not easy to answer but I will try.

First, I will define "base money" as being money coming from the central bank. Having said that, I immediately ask if the CB borrowed this money from private sources or did the CB sit with treasury to make an inter-office loan (which enables government to pay it's bills). One path clearly borrows existing money and the second clearly creates money from nothing.

Does it make a difference? Well, does the CB have any source of income (such as taxation) that allows it to buy bonds from the private sector? I think the answer is "no". If no, then the only source of green money that the CB has is to print money. (of course, this is done by lending money.)

So, repeating, does it make a difference whether the CB buys bonds from private holders or from the government office of the treasury? No, all CB money used to buy bonds is printed. Only positive money is used. No negative money at all, only a loan document promising to repay what is given (sometime in the future). Nothing negative here at all.

So far, I am only recognizing the presence of green money. We should ask if commercial banks can create red money? I think the answer is the same, no. I think commercial banks also create money out of nothing. This is also all positive "green money". Like the CB, the commercial bank exchanges a bank deposit for a loan agreement. Two assets are created, both with positive value from the perspective of the macro-economy.

Does this make sense so far?

What bothers me and connects with your not-yet-revealed gift economy is the situation that develops when the loan document fails for any reason. If the loan fails, there is no valid repayment commitment. Without a repayment commitment, the asset called "new money" is never destroyed. Someone will get a gift (a positive asset) that they would not have had except for the deposit/loan creation (and ultimate failure). In other words, the loan fails, the money will survive.

I am sure that you are noticing that I have only discussed positive money. I just don't see where we can ever get negative money (red money) from the perspective of the macro-economy.

Yes, in that regard. But I'd approach this the way Keynes approached it (my footnote 2):

"Properly speaking, unused overdraft facilities – since they represent a liability of the bank – ought, in the same way as acceptances, to appear on both sides of the account. But at present this is not so, with the result that there exists in unused overdraft facilities a form of Bank-Money of growing importance, of which we have no statistical record whatever..."

Keynes' use of the words "...at present this is not so..." suggests that this is a discrepancy that should probably be amended. His "on both sides of the account" can be translated as on-balance-sheet.

Whether it's on or off balance sheet, I don't think this directly affects the relationship between the bank and the customer, as defined in the credit/"loan" contract. It affects statistics, and probably some regulatory requirements. You might know more than me about the latter?

Roger said: "Without a repayment commitment, the asset called "new money" is never destroyed. Someone will get a gift (a positive asset) that they would not have had except for the deposit/loan creation (and ultimate failure). In other words, the loan fails, the money will survive."

I think here it helps to widen our perspective a bit. If a loan fails, something is destroyed. What? A credit balance belonging, or which could have belonged later, to a shareholder. If you're familiar with Modigliani-Miller, this is related to that. Equity is a credit balance, just like "deposits" are.

Once the "deposit" credit balance is created, there is no link between it and the loan. After that, our focus should be on debits and credits in total. For instance, the "deposit" created could be converted to equity or a bank bond. It wouldn't make the credit balance disappear; it would only change its form.

Well, I'm not an accountant, so this is only my layperson's idea of what accounting means: the idea seems to be to arrive at a system that (ac)counts real world phenomena as precisely as possible. One objective for example is consistency, which is why phenomena are categorised and treated equally within categories. Also, there are rules that have been agreed upon, terminology etc.. A whole bunch of formalities with the impossible objective of capturing the real world exchanges that people, firms and countries engage in. Conversely, by way of contracts and other standardised procedures, accounting and finance also influence the way we do business. So it isn't quite clear which way causality runs.Nevertheless, I think it is safe to say that accounting itself is to a certain extent an abstraction of that which it wishes to capture. Detail is lost along the way. My loan looks like your loan on paper, even if we're fundamentally different people doing fundamentally different things. That 'discrepancy' will never be overcome.So, in studying the world, we must keep an eye both on that which is being accounted for (the territory, if you like, as a static analogy), but also form a theory about the way in which it is being accounted for (a theory of the map). That way one can establish a map-theory relation.

https://en.wikipedia.org/wiki/Map%E2%80%93territory_relation

The (critical) realist (or epistemologically idealist) position would be that the territory is real, it exists outside of our minds, whereas accounting is the mental tool (the idea) by which we attempt to capture that reality with our minds.

The (strong, ontological) idealist position would maintain that both the territory and the map are mental constructs and thus fundamentally on the same level.

But don't worry, I'm a hack at philosophy just as much as I am at economics. I just prefer to think laterally as well as vertically. Deformation professionelle, I suppose. I'm originally an architect - we take pride in knowing virtually nothing about absolutely everything.

Keynes seems to have been rather fuzzy about the issue, especially in terms of real-world revocability concerning such facilities. Following the same fuzzy-set logic, we might as well include other undefined kinds of 'potential' new loans into the same category. But I see no analytic/scientific reason to subsume potential usage with actual usage. I.e., there's no reason to categorically assume undrawn credit lines as (a) irrevocable in the legal sense, or (b) as if they're already used/drawn in the economic sense.

The legal treatment of off- vs. on-balance sheet items is different. The type of undrawn credit lines you allude to is for most parts associated with uncommitted facilities. That means the lender can suspend the facility if market conditions so require, and repayment may be on-demand. Legally that's quite different from committed facilities. Also, non-performing overdrafts, on-balance sheet, are usually converted into ("traditional") loans with fixed amortization schedules (in a way, more in line with how committed facilities are treated).

I think you run into "real-world-relevance" trouble with your example when you sacrifice balance sheet congruence for numerical congruence.

Antti: Yes, that makes sense. A quick recap-- deposits and loans are both assets; the only difference is the time effect between the two.

In your comment, you write "If a loan fails, something is destroyed. What?". My answer to that question is somewhat philosophical. I think an asset-path-to-the-future is lost. The loan has no obvious present value except as to whatever predictability it might offer for the course of future events.

I think you are correct to observe that a bank deposit is identical to a loan in every respect except one: the bank deposit is a present-realizable asset-path-to-the-future while a loan is a future-realizable asset-path-to-the-future.

What is a "drawn" credit line (I used the word 'credit line' as a synonym for an overdraft) to you? To me that means that you have already bought something. That's why it is comparable to a "loan" that is already used to buy something (ie. loan account and checking account don't net to zero, or positive), not to a "loan" that is "booked" but not used to buy something.

I have also explained already that I'm talking about the accounting treatment only. By this I mean that there is a credit contract behind the overdraft, and that contract might for instance (you should here forget what is common in practice) say that this is a 10-year overdraft, where the limit is to be reduced monthly by a certain sum.

In the real world there are also many "traditional loans" which don't have any pre-agreed amortization schedule, so, in theory, I don't see any difference between an overdraft and a traditional loan. That's what this post is about. It seems you define an overdraft as something which cannot have a fixed amortization schedule:

"Also, non-performing overdrafts, on-balance sheet, are usually converted into ("traditional") loans with fixed amortization schedules (in a way, more in line with how committed facilities are treated)."

? Also, if I'm not mistaken, the bank can "book" a traditional loan but can still at that point, before it's used, require an authorization from the bank when the customer makes the purchase. It's not up to the customer to use the "loan" as he likes.

But perhaps there is nothing interesting in my point about the accounting treatment being theoretically identical in both cases? I'm stressing this point so that we can agree that a "traditional loan" can always be modelled as an overdraft when it comes to the accounting treatment.

As I hinted, I don't see any reason why we couldn't have always had only overdrafts, ie. we could have done without a separate loan account. In my eyes it doesn't bring any extra value, and all the real-world variation between an overdraft and a traditional loan is based on variation in the related contracts.

In theory, I don't see any reason why a traditional loan couldn't be just as revocable as an overdraft. It's the actual contract that matters.

Johan: Could it be that you think that only a used overdraft is "money borrowed", whereas in the case of the two-account treatment ("traditional loan") "money is borrowed" already when the credit entry is made on the checking account?

I just thought this might be the case because you talk about "other undefined kinds of 'potential' new loans".

I recognize the problem with trying to describe real world in terms of accounts and numbers, although I somehow connect it more to cases where the accountant himself, or the company in general, must come up with a figure that is hard to verify and where the range of acceptable, or non-falsifiable, numbers is very large.

I guess goodwill is the clearest example available. Did we pay too much for the firm we acquired? No, the related goodwill, which is going to be booked, must be at least 10 million euros. You don't agree? Well, then show me where I go wrong.

But I think your point is generally valid. Non-performing loans are just such cases where it is hard to say how much they are worth. And many (you might ask: how many? exactly...) performing loans are potential non-performing loans.

The profession's answer to this problem is the prudence concept. That works best when the accountant is like me: a person of high moral standards, an independent mind, not easily bullied by superiors ;-) (Yes, I could have been a whistleblower.)

But I have to admit that I've missed the connection between what you're saying and what I've been saying. Where did you get the feeling that I might overlook this problem?

The discrepancy I talked about was about what I saw as illogical use of language ("debt repayment").

Well, Antti, simply using ECB terminology: overdrafts are debit balances on current accounts.

So, when you have a line of credit it may be drawn (as in your example for the overdraft part item # 2) or undrawn (as in your example for the overdraft part item # 1). #1 (undrawn) is off-balance-sheet but # 2 (drawn) is on-balance-sheet. From the traditional loan perspective, as per your example, item # 1 is already on-balance sheet, regardless of whether you have bought something or not. That was the incongruence I initially spotted; as them having different starting points in terms of on-off balance sheet treatment.

Hope that helps?

Sure, it's the contract that matters. Which is probably why we have variations of overdrafts as well as variations of "traditional" loans; i.e., variation between contracts and types of accounts. Not because they couldn't in theory be brought into equivalence, but because they *remain* different in terms of legal treatment and other aspects. So, there seems to be a real world (practical) demand for inequality between these two broader categories.

"That was the incongruence I initially spotted; as them having different starting points in terms of on-off balance sheet treatment."

Yes, but that's one of the points I wanted to make (and which Keynes made, too). Why are they treated differently? Why is one on-balance sheet from the start and the other isn't?

Look at the equivalence from this angle:

The situation is as described in item #1. The next minute, the account-holder instructs a debit on his checking account (makes a purchase). The bank accepts it (because in the contract it has agreed to accept it). So, we have moved to item #2. In both cases, the customer is now indebted, and, let us assume, has to sell goods to pay his debt. The equivalence is clear. Why shouldn't there be a similar equivalence at item #1?

A positive balance of 1000 with a limit at zero should be equivalent to a zero balance with a limit at negative 1000.

You said: "So, there seems to be a real world (practical) demand for inequality between these two broader categories"

I agree that they are used in different ways in practice, and the differences in legal and regulatory treatment probably provide a good reason for this. But is this "demand for inequality" you talk about something that couldn't be met in the overdraft-only world by contract design alone?

In my view the difference might be a "historical accident". The conventional accounting treatment was consistent with the idea that one has to have "money" on one's account to be able to "make payments", ie. "transfer money", to someone else (see my discussion with JKH). Scots broke this illusion in the 18th century, by realizing that a checking account can be debited even if there's no credit balance on it, and this results in a debit balance. Overdraft was born.

Somehow missed this one: Antti wrote: "Johan: Could it be that you think that only a used overdraft is "money borrowed", whereas in the case of the two-account treatment ("traditional loan") "money is borrowed" already when the credit entry is made on the checking account?"

Yes, that's it.

Now, when you talk about the "discrepancy"… I would say that the accounting treatment is not identical. There's incongruence in the beginning of the exercise – one side being off- and the other on- balance-sheet. And then there's incongruence at the end of the exercise – one side, again, being an off-balance-sheet adjustment (overdraft credit limit) and the other an on-balance-sheet adjustment (amortization of the loan). Therefore, we should probably expect there to be a "discrepancy" rather than be surprised about it.

Antti: “Had the accounting treatment always been that of an overdraft, not of a traditional loan, the words and concepts we use might differ from what they are today”

The words and concepts are vital elements of this type of modelling. I don’t think it’s possible to agree these things in advance of creating a model. Each modeller has to use his own words and concepts. There is nothing wrong with this as long as each modeller defines his words and concepts clearly.

I think that my use of words and concepts is pretty clear. I think that people should be able to UNDERSTAND what I am saying even if they don’t AGREE with what I am saying. Both are required to get a successful real-world conclusion. On the internet, getting to understanding would be a triumph.

It doesn’t matter that your terminology is different from mine as long as we discuss my model using my terminology and your model using your terminology. We can’t mix the two.

Roger: “In this, you would be agreeing with Sinn who argued that TARGET2 positive balances are debts-at-risk”

Another problem in this stuff is that people change the subject at the drop of a hat. TARGET2 relates to the Euro. It might be interesting but it is an unnecessary detour from the core of the discussion. (I know that Roger didn’t introduce TARGET2 into the discussion. It came from Nick’s blog).

But I have to admit that I've missed the connection between what you're saying and what I've been saying. Where did you get the feeling that I might overlook this problem?

The discrepancy I talked about was about what I saw as illogical use of language ("debt repayment").

I'm sorry if I've drifted from the subject at hand. Without going back over the drivel I've spilt here or elsewhere I think by discrepancy we might mean something different. What do you mean by illogical use of language? Internally inconsistent? Or inconsistent with the real world phenomena it's trying to depict? Which phenomena?

Do you see any such thing as 'the economy'? Something that is distinct from accounting (which would then be more of a handicraft) and the apples & haircuts that humans exchange in every day life?

I'm still mulling over your initially stated intention to create a model of the economy as we see it but without money. I'm wondering whether you're trying to look 'behind the map' of accounting as it is practiced in order to see only the economy of real goods and services, thus relegating the accounting to the position of passive bystander. In which case my objection, if only on the margins, is that there is a reflexivity, a feedback, between that which is being measured and the art of measurement.

If that makes even the slightest bit of sense...

In any case, don't feel obliged to come up with a reply to every comment of mine. Only what you're interested in.

Replying to myself after reading your answer to Johan above, I think it is sort of an accounting internal issue you're getting at, at least with your overdrafts = loan equivalence. According to you, the concept of a loan is based on the idea of money being an object. Drop that assumption and loans become logically equivalent to overdrafts. Problem is, they aren't functionally equivalent in the reality we've created for ourselves irrespective of whether that reality is based on a fiction. When it comes to ideas, and I would count in contracts etc., we have the power to create our own reality from any collective fiction we please.

Johan said: "I would say that the accounting treatment is not identical."

Sorry, I chose my words very badly, lazily. As I wrote in the post:

"If the accounting treatments are identical in their outcome, then why this discrepancy?"

The accounting treatments differ, but their outcome, or that which is being (ac)counted, is the same.

I'm not surprised by the discrepancy, but I nevertheless think it shouldn't exist. I do understand you don't think the same, and that's because you see that this is about "borrowing money".

You know quite well where I come from. To me, this is about recording non-bank liabilities, or debts, and non-bank "claims" (on the community as a whole) or "credits". When a traditional loan is booked, the non-bank customer in question doesn't yet have any debt. The records as they stand after the booking of the loan -- now we look away from the credit contract -- don't carry more information about the non-bank customer's position than the off-balance-sheet records of a granted but unused overdraft carry.

The case of two paradigms is of course an extreme case of what you are talking about. I take you to be talking mainly about "commensurate languages", where I can use a different word than you, but the concept behind the word, or the word's meaning, is the same. That would mean that a dictionary is all we need, and we can create it.

Kuhn is talking about cases where it is impossible to create the dictionary, because it's the concepts used, not only words, that differ. To understand what I mean, you need to understand my "world-view".

I think there are signs of this kind of "incommensurability" in my discussion with others. I'm not just calling "money" with another name, as I would be if I said that there are "credit balances" on checking accounts and that those balances can be transferred from one account to another (the balances are a 'thing', something that can be transferred). Instead, I'm saying that there is nothing on the account that can be transferred. I think it's hard for some people to grasp what I mean by this, or is it?

From your comment to Roger: "Yes, but a deposit is an asset of a non-bank (it’s a liability of the bank)"

I recall that you have at least one point hinted (agreeing with Nick) that it might not be a "real" liability of the bank, but that in conventional accounting language it is presented as such. Or do I remember wrong? This is probably easiest to understand in the case of a central bank. I just wanted to hear your thoughts on this.

I don’t think that I worded one of my comments from yesterday very well (10:59 AM). I was trying to make a general point about focus but it might have read as though I was being critical of Roger (despite my disclaimer at the end). That was not my intention.

If these discussions were in the real world, we might hold a workshop where someone like me was facilitating.

One of the biggest problems in this situation is to ensure that everyone debates the same subject at the same time. There are various ways of doing that from using the brute force of the “baseball bat” technique to agreeing to hold separate sub-workshops to discuss specific topics.

Roger’s mention of TARGET2 reminded me that, in Nick’s threads where there are many commenters, there are often multiple conversations going on at the same time and it is often difficult to follow and labour-intensive to read comments only to find that, after reading them, they are discussing a completely different topic.

That’s why I didn’t want to discuss my views of Antti’s work on Nick’s comment stream. It would be difficult for others to follow if I commented there on something Antti had written here which also referenced something that Roger had written on his blog.

It is usually more effective to hold focussed discussions between a smaller number of people. The smaller group can then discuss whatever it likes without distraction from others, and vice versa.

Oliver: I appreciate all your comments very much and I'd consider it as a loss if you stopped providing them. I'm "all over the place", in the sense that I find it useful to discuss this matter both on a more philosophical level (with you) and on a more technical, detailed level (with Johan).

My main argument is not about the detailed, practical level. I want to present the "Weltanschauung" I've arrived at through my work. And I assume that is what you, too, are interested in?

When I say that I see a world without money, it means very much what I've been debating with JKH lately. And my view seems at least partly compatible with Quantum Economics. I do see, and recognize, the credit balance on a checking account, but it is not something that can be transferred away from the account. I see a world where there are no "money flows", or "flow of funds", and in the framework I use (to make sense of phenomena) it would not make much sense to talk about such flows. The meaning I give to the accounting entries is such that it wouldn't make sense to talk about the balances as something that can be transferred (to another account).

Within the same framework, what others might call the "creation and destruction of money" becomes just a natural part of the accounting performed; there's nothing special about it.

You said: "What do you mean by illogical use of language? Internally inconsistent? Or inconsistent with the real world phenomena it's trying to depict? Which phenomena?"

What I thought I did in my post is that I showed, by revealing the equivalence between an overdraft and a "traditional loan", that it doesn't make sense to talk about "debt repayment" like we do:

"For instance, we would repay debt when we sell goods (item #3 in my document), not when the overdraft/credit limit is reduced (item #4). The latter is how we see repayment when we think of a traditional loan."

That the amortization of the loan, item #4, is actually equivalent to (or, it is) a reduction in the credit limit. That debt is repaid in both cases at the time of item #3.

But it seems I have failed to achieve this, and this is at least partly because others think in terms of "money borrowed", and see a traditional loan somehow different in that sense. That there is a liability to "return the money" to the bank, and that liability is the debt. Or something.

My point is that we can take the traditional loan and convert it into an overdraft, without touching the credit contract.

You have a 20-year mortgage you took five years ago, $250,000 of which is outstanding, and you have a $5,000 balance on your checking account? OK. Let's convert it into an overdraft.

Now you have a total overdraft limit of $250,000. You have an unused overdraft of $5,000. Your checking account balance is negative (debit) $245,000. Your overdraft limit will be reduced monthly by the same sum as was your "traditional loan's" monthly amortization. Interest charges will be debited on your account just like they have been debited until now. (The interest charges in these two cases can be made equivalent by setting one interest rate on used overdraft and one interest rate on full overdraft limit, reflecting the interest charged on the traditional loan and interest earned on a credit balance on checking account... if any.)

So, I'm saying that this overdraft has now replaced your traditional mortgage and still nothing essential has changed. Other than that now we say that you repay some of your debt every time there is a credit to your account and incur some new debt every time there is debit to your account. We don't say that you repay your debt, or your loan, monthly when the overdraft limit is reduced.

What has changed so much, when going from a traditional loan to an overdraft, that we should recognize debt repayment happening at a different moment?

"The interest charges in these two cases can be made equivalent by setting one interest rate on used overdraft and one interest rate on full overdraft limit, reflecting the interest charged on the traditional loan and interest earned on a credit balance on checking account."

If

X is the interest charged on the traditional loan, andY is the interest earned on the credit balance on checking account, then

Y is the interest charged on the used overdraft, and(X-Y) is the interest charged on the full overdraft limit.

Antti: "But is this "demand for inequality" you talk about something that couldn't be met in the overdraft-only world by contract design alone?"

From a historical standpoint: How do you get such contracts to work properly when the technological development in terms of informational distribution is limited and most people don't even have bank accounts; and the ones who have, only infrequently transact with the bank?

Remember, in 1728 William Hog was a merchant in Edinburgh at the time where most merchants in the area knew each other, which also made it easier for banks (for example, the newly established RBS with plenty of shareholder's cash on hand) to know who it was dealing with and regularly monitor a merchant's cash flow/credit standing. The first overdraft was originally formulated as 'cash credit', implying not only debit-credit entries on the bank's book, but cash flow in and out of the bank. Considering the technological development at that time, it would probably have been rather difficult to generalize or expand an overdraft system into something of a norm for all simply from an information processing standpoint.

The ingenuity of the RBS-Hog deal wasn't just the debit balance, but also the uncollateralized (in a way, personalized) nature of the contract. That, in turn, invites a closer informational relationship with the account holder and the bank. Introduce stricter or more standardized collateral requirements and you lose much of the flexibility… that's also the way towards a traditional loan where the bank simply books the collateral as an asset to guard itself against insufficient customer's cash flow.

Antti, regarding on- off balance-sheet handling: A promise to lend when the borrower may or may not utilize such possibility to borrow at some future time, and when the bank (often) *still* retains discretion whether to fulfill the promise contingent on circumstances… seems to me rather unnecessary to have on-balance-sheet.

Johan: Interesting thoughts on the situation in the 18th century! But I don't see that you answered my question. The only thing I'm concerned with is the accounting treatment, and it is related to what you say here:

"A promise to lend when the borrower may or may not utilize the possibility to borrow at some future time, and when the bank (often) *still* retains discretion whether to fulfill the promise contingent on circumstances… seems to me rather unnecessary to have on-balance-sheet."

My point is not that an unused overdraft necessarily should be on-balance-sheet. My point is as well compatible with a booked, but not yet used "loan", being off-balance-sheet. As I said, there the bank, too, usually retains discretion. It will allow it to be used only for the purpose defined in the credit contract, and that means it will only agree to credit a certain seller's account when the purchase is made by the loan customer.

If you imply that the "loan" is surely to be used, unlike an overdraft, then why not wait with the booking (bringing on-BS) of BOTH until they are actually used?

You paint a broader picture of that first overdraft very nicely, and I thank you for that. But as I said, my focus is here more narrow. My focus is on the discovery that the checking account balance could become negative, which means that there didn't need to be "money" on the account for "money" (figuratively) to be transferred from that account to another. How do you see this? Have I possibly misunderstood that this fact was somewhat surprising for most of the people at the time?

Antti: "My point is not that an unused overdraft necessarily should be on-balance-sheet. My point is as well compatible with a booked, but not yet used "loan", being off-balance-sheet. As I said, there the bank, too, usually retains discretion. It will allow it to be used only for the purpose defined in the credit contract, and that means it will only agree to credit a certain seller's account when the purchase is made by the loan customer."

The reason why a booked (traditional) loan not yet used being on-balance-sheet is the fact that the booking itself sets in motion a set of obligations for the borrower inasmuch as interest starts to accrue. It also sets in motion a set of obligations for the lender in terms of paying interest on the deposit and other regulatory aspects. It directly affects the income statement and thus should be on the balance sheet, as per current practice.

One might think that the receiver of an overdraft promise also has to pay something for such convenience, but it seems rather contrived to think it should always happen to be priced to same effect as the spread between interest on the loan and the interest on a deposit. In that case, unless you know you will use the overdraft facility, you opt out or bloody well use it as soon as possible and draw, so as to not having to pay interest on something you're not going to be utilizing – especially if the limit is set to a large amount.

Antti: "How do you see this? Have I possibly misunderstood that this fact was somewhat surprising for most of the people at the time?"

I don't claim expertise in the issue. But I think Benjamin Geva mentioned something to the effect that goldsmith-bankers in London (the context is given as concerning the second half of the 17th century) "avoided depositing large sums with each other by routinely creating overdrafts. Stated otherwise, a goldsmith did not demand from a fellow-goldsmith a positive balance as a precondition for paying an instrument presented to him by the fellow-goldsmith."

So I don't really know it the RBS-Hog deal was just the first of its kind between a bank and a customer or the first of its kind ever? In a way I still think it was a novelty among the general population, at least among the merchant class, but then again, the general population didn't use banks all that much in their daily transactions.

For instance, we would repay debt when we sell goods (item #3 in my document), not when the overdraft/credit limit is reduced (item #4). The latter is how we see repayment when we think of a traditional loan.That would fit with my home grown definition of 'looking behind the map', the selling of goods being that which takes place in the 'real world' and which triggers activities on at least two, if not more ledgers = the maps. I agree. And thanks for the interesting discussions! If you're ever in Zurich, come by for a beer (or bring a bottle of Finnish vodka, although the same bottle is probably cheaper here) :-).

Jamie said: "Thanks. That gives me a better idea of what you mean. I think that there are two separate issues here. First, how does the banking system intervene to support the rest of the economy on a transaction by transaction basis? Second, how did the banking system get started and what keeps it afloat?"

Does the first one include whether commercial banks are creators of "money"?

"First, I want to lose the term “hedge fund” and just call it “commercial bank”."

OK. Just keep in mind these:

What happens when a central bank does QE?

What happens when a commercial bank does QE?

What happens when a hedge fund does QE?

"That’s not what happened. I think that the story is something like:"

I thought some entity wanted to start from scratch, not what happened in the past. Most economists would skip any type of gold standard if starting from scratch.

"This brings us back to the current discussion which, from my perspective, is that the terms “money” and “loan” (or debt or bond or overdraft) are closely related but not the same. We don’t use short term debt as money. We acquire debt in order to acquire money (purchasing power) at the same time. We then spend the money but are left with the debt. Money is the medium of exchange. A loan (or debt or bond) is not."

Here is the interesting one.

Would you consider demand deposits MOE?

And if so, why are demand deposits not a type of short-term debt (a day or less) with some different “rules” applied to them than other short-term debt?

When "getting a loan", is an entity borrowing demand deposits from the commercial bank?

I fear you have moved into an untenable logic trap. Or maybe the trap has me? The trap is the concept that money is not physical and real.

Am I right--you think accounting entries are not physical. They are just symbols or marks.

Well, from my mechanical perspective, I notice that each mark is made with a physical device using a material like ink or carbon or electrons or magnetic structures. Because marks are physical, the mark can be made by one person and observed by another.

Well, maybe the observation that the accounting record is a physical device is not the kind of physical embodiment you are trying to clear our minds of.

In Nick's blog, you wrote

"Roger: I think you should forget real assets. It doesn't matter here. What we are talking about is entries on accounts in a bank's ledger; specifically, on accounts where the account-holder is a non-bank. The bank accountant doesn't care if behind the instructed entries is a transaction where I bought a bicycle from you. He just debits my account and credits yours."

Here I worry about your logic. You paid me with a mark on my account. I claim that I now have a physical mark that has some value. I think others can observe that mark and agree that I have a value in my account. By my logic, with the sale of the bicycle, I have increased my account by adding a real asset.

You can logically ask if my account is now positive or is it negative? It should make no difference. It is immaterial to the question of whether the mark represents a physical asset. Both positive and negative marks have meanings that record the objective of the recorder.

Maybe I still have not captured your logic that real assets are not being recorded. Are you thinking that the original positive mark was offset with a negative mark (as in a bank deposit/loan origin)? The offset logically results in nothing real having been created?

I doubt that you believe that. By using positive numbers, we acknowledge that real values exist. By using negative numbers, we recognize that real value does NOT exist. A negative account value would recognize that alternative ways of achieving value are in place. (For example, a negative account would have a loan agreement as an attachment, expressing in detail the repayment expectation.)

As I said, I doubt that you believe that the deposit/loan bank money creation event creates nothing. But should you think that equality exists (green/red money), think of an event of loan failure where a loan is never repaid to the bank. If money was created by the loan, it remains (does not disappear) when the loan is never repaid.

Roger said: "Well, maybe the observation that the accounting record is a physical device is not the kind of physical embodiment you are trying to clear our minds of."

Correct. I'm not saying the record itself is not physical. I'm saying that the record cannot be transferred. The balances on accounts can only be changed, by making entries. They cannot be transferred.

Roger, I'm not Wittgenstein :-) Real assets, sometimes called "physical assets", are non-financial assets, like the bicycle. I only meant that the bank doesn't record non-banks' holdings of this kind of assets. The bank records only non-banks' financial positions (liabilities AKA debts, and financial assets AKA financial claims AKA "credits").

You said: "As I said, I doubt that you believe that the deposit/loan bank money creation event creates nothing. But should you think that equality exists (green/red money), think of an event of loan failure where a loan is never repaid to the bank. If money was created by the loan, it remains (does not disappear) when the loan is never repaid."

Records are made. That's what happens in the "loans create deposits" situation. In the end it's not helpful to think that some specific, as if it was almost "ear-markable", "money" is created which exists until the loan is repaid (I used to think like this before, so I know what I'm talking about).

Credits=debits, always. If the loan is defaulted on, it is going to be written off, and that is done by crediting the "loan account" and debiting some other account (probably "Credit losses" in a textbook case). This ensures that there is no "widow-money" flowing around, without a corresponding debit (or "loan").

Looking at things from your perspective, I'd suggest you consider this: That credit loss will decrease the earnings of the bank, assuming positive earnings, and if all earnings were distributed as dividends, there would be "money created" on a shareholder's account. Now that "money" won't be created. That "money" was destroyed when the loan was written off.

Oliver: Thanks for the offer! I'd be happy to come by. And if you're heading to Oslo, let me know. Or even Helsinki, where I'm every now and then. Take a case of vodka with you, if it's so cheap there! Vodka at Oslo airport (outside EU, just like you...) is very cheap, too.

What you say about the map is right. There is "real world", and then there is accounting. "Money" is part of the accounting, not the "real world". That's why money doesn't flow, and we can describe everything having to do with money as "records changing previous records" (an entry changing an account balance).

Johan: Thanks for the Geva links! My initial search on the history of overdraft returned very little, so I appreciate this.

You said: "One might think that the receiver of an overdraft promise also has to pay something for such convenience, but it seems rather contrived to think it should always happen to be priced to same effect as the spread between interest on the loan and the interest on a deposit."

Again, you are talking about the contracts. I only wanted to show that an equivalence can be established between the interest rates. Similarly, you talk about contracts when you say that the loan affects income statement right away. Not necessarily, nor in a different way than an overdraft might affect, given a certain credit contract.

"My point is that we can take the traditional loan and convert it into an overdraft, without touching the credit contract.

You have a 20-year mortgage you took five years ago, $250,000 of which is outstanding, and you have a $5,000 balance on your checking account? OK. Let's convert it into an overdraft.

Now you have a total overdraft limit of $250,000. You have an unused overdraft of $5,000. Your checking account balance is negative (debit) $245,000. Your overdraft limit will be reduced monthly by the same sum as was your "traditional loan's" monthly amortization. Interest charges will be debited on your account just like they have been debited until now. (The interest charges in these two cases can be made equivalent by setting one interest rate on used overdraft and one interest rate on full overdraft limit, reflecting the interest charged on the traditional loan and interest earned on a credit balance on checking account... if any.)

So, I'm saying that this overdraft has now replaced your traditional mortgage and still nothing essential has changed. Other than that now we say that you repay some of your debt every time there is a credit to your account and incur some new debt every time there is debit to your account. We don't say that you repay your debt, or your loan, monthly when the overdraft limit is reduced.

What has changed so much, when going from a traditional loan to an overdraft, that we should recognize debt repayment happening at a different moment?"

Antti wrote: "I'll quote my comment to Oliver above (this is my main argument -- let me know how it sounds?) […] What has changed so much, when going from a traditional loan to an overdraft, that we should recognize debt repayment happening at a different moment?"

#1

Ok, I will try to answer. In short: there's no real discrepancy and nothing essential has changed, and we would see that if we, for example, also had records on monthly income, monthly living expenditure and an end-of month balance comparison. What seems to confuse in your example is the assumption that the overdraft credit limit is analogous/equivalent to the outstanding loan at each point in time in a two-account treatment. It is not. When you consolidate the loan account (mortgage) and the checking account into a single overdraft account like that, the overdraft credit limit gets a new meaning: it is more akin to *an assessment of the overall creditworthiness of the account holder* than anything else. So as with each increment of mortgage-loan repayment on schedule, the creditworthiness of the account holder, thus the limit, should be extended rather than reduced. The proper analogy for the overdraft credit limit within a two-account treatment would be something like *the amount of a new loan the account holder could get from the bank should he ask for it*. As he pays down his mortgage debt, the value of a new potential loan he could get should rise as the current one is reduced. Even if it would be zero at start (with a current mortgage at 250 000 as the maximum the bank would allow for him at that point).

Let's make some calculations. Say, the account holder is payed at the beginning of each month a salary of 20 000, from which 10 000 is used to pay for living expenses during the month, and the rest (10 000) is used for repayment of the mortgage. That's the whole schedule. (I abstract away from interest as it makes the calculations easier.) Should we compare the overdraft position with the overall position in the two-account model, we would have exactly the same end-of-month position each month. So, start with an end-of-month (debit) balance at -245 000; new month; salary received will decrease the balance immediately to -225 000; paid living expenses during the month will gradually increase the balance to -235 000; end of month balance = -235 000, i.e., the mortgage debt to the bank has been reduced by 10 000 and the account holder is 10 000 closer to become debt-free house owner. Which ought to mean that his credit worthiness has improved by 10 000 ceteris paribus. In the two-account treatment the end-of month position would be the same: loan account 240 000, checking account 5 000.

Considering the information you gave in your example, there is no such thing as a separate repayment of mortgage debt from salary received; both are bundled into the same enactment. Every time a salary is paid into the consolidated account it is treated as if the whole of the salary went into repayment of debt (or into reducing the debit balance). And every time there is a living expense paid for during the month, it is as if a new debt has emerged (or that the debit balance has increased).

In the two-account model the sequence is usually slightly different. Assume loan repayment is automatized and performed the second after the salary is registered on the checking account. Hence, loan account status just before salary payment is 250 000, checking account status is 5 000 (overall balance = -245 000). Loan account after salary is 250 000, checking account balance is 25 000 (overall balance = - 225 000). Debt repayment and we have: loan account 240 000, checking account 15 000 (overall balance = -225 000, the same overall balance as before as it's just an internal adjustment between the accounts). After living expenses paid we have the checking account at 5 000 (overall balance -235 000). And that would be the same as the overdraft account at the end of the month.

"Ideally", the overdraft credit limit should increase with each increment of a monthly debt reduction so as when the whole mortgage is paid the limit would stand at -500 000. Then assume a new loan for the purchase of a bigger house worth 500 000. The account holder is, after all, now a debt-free owner of a new house worth 250 000. So now the account is drawn, maxed-out, at -500 000. That would be the same as in a two-account treatment after house purchase with a loan account at 500 000 (also assume checking account at 0 for simplicity). Sell the old house for 250 000 and the overdraft balance goes to -250 000. In the two-account model the balance would be the same: loan 500 000, checking account 250 000. Make an instant repayment of the loan with the same amount and we have loan 250 000, checking account 0. Convert the two-account model into an overdraft model simply by putting a minus sign in front of the loan account's 250 000 = -250 000. And there you have it… the cycle may start again.

I certainly welcome , your comment . We are getting right into the heart of the issues here.

I agree with this quote of yours: "The balances on accounts can only be changed, by making entries. They cannot be transferred." While agreeing, it is obvious that a flow (or some kind of change) has occurred that makes a new entry necessary. Are we still together with this observation?

We get even closer to the heart as you continued your comment. I liked your response to my question/observation ".......If money was created by the loan, it remains (does not disappear) when the loan is never repaid."

Your used the bank balance sheet revisions as an example of loan failure, explaining that the bank shows a loss of assets. Using double entry, the loan asset (LHS?) was paired with a liability loss, probably labeled as stockholder equity (RHS?). (Are we together so far?) I would agree with this but it does not speak to the positive deposit mark made when the loan was created.

My position is that the deposit was spent into the larger economy, causing positive marks in other accounts, most not residing at the bank originating the loan. It is these accounts that remain permanently larger due to the failed bank loan.

I can see that this (just made) argument takes us back to question whether the original bank loan actually created money. In other words, did the bank lend money it already had or did the bank actually create money?

I will try to answer that question. I think it did BOTH! My reasoning is simple. We actually have two time periods and a different answer for each time period.

1) First time period while loan is "safe". Money has been created because bank customers can add all CUSTOMER deposits on account at the bank and observe that the total has increased by the amount of the loan.

2) The second period which follows loan failure. The BANK adds all deposits in accounts under it's control and observes that there are no changes despite the change in loan failure status. What we might call "the money supply" has not changed.

You are a good accountant and probably see that we have drastically changed the perspective between these two time periods. First we considered ONLY customer accounts and secondly, we considered the accounts controlled by the bank. You, by now, probably have noticed that we DID NOT consider the bank's own deposit account during the first time period.

What was just described occurs in the case of private banks. Are you with me so far? This is complicated stuff and it is very easy to miss important, vital, details. (And I write in a complicated, interlinked fashion. Sorry, I am trying to make my work easier to read.)

If we have only discussed private banks, what about central banks? Well, central banks have no asset base (comparable to private) at risk. Instead, the CB always has the ability to self-lend. The CB can truly "print money". (Of course, this is what is happening in a country like Venezuela today.)

This takes us back to case 2. Whose money would the private bank be lending if the bank does not truly "create money". I have to logically speculate here. The money loaned could have been the loan money that flowed from a third bank , OR, the money loaned could have come from the CB who "printed" it .

Are you with me at this point? You can see that I both agree and disagree with you. My words attempt to logically connect all the many links that exist in the modern fiat money system. While it might flow and link correctly from a mechanical perspective, does it connect from the accounting perspective?

I am sure that you notice that I still only use positive money. My accounting standard requires that negative entries indicate a uniform zero equity ownership by the account holder. Any negative amount shown is indication that an off-account relationship exists and has an estimated asset value.

To conclude, you ask "How does this sound?" You can see that I thought it sounded incomplete. Now, I ask "How does this sound?"

(Thanks for the detailed comment. It really delves into the heart of the money system. ) :-)? :-(? :-)

Roger said: "My position is that the deposit was spent into the larger economy, causing positive marks in other accounts, most not residing at the bank originating the loan. It is these accounts that remain permanently larger due to the failed bank loan."

No, Roger. What I'm trying to say is that the initial link between the debit ("loan") and credit ("positive mark" or "money") is fully severed, forever, once the "positive mark" ends up on a seller's account. It's not anymore the same "positive mark" as it was when it was on the loan customer's account. It has a life of its own now.

A simple case to prove this:

The seller, after having received a credit on his checking account ("money"; assuming positive balance), subscribes to a share issue by his bank. What happens? The "positive mark" is DESTROYED (the bank debits his checking account and credits equity). The loan remains.

As you see, it works the other way, too. Can we say that loans are now permanently higher? I don't think so. As long as credits=debits, there is no problem.

Antti said: "...It has a life of its own now". I fully agree this far.

You go on to offer "A simple case to prove this". I'll paraphrase here, hoping I have the argument in grasp: The seller (meaning the secondary owner of the money created by the loan) subscribes to a share issue by his bank (meaning not the same bank as originally issuing the money generating loan). The positive mark is DESTROYED.

I find myself disagreeing at the thought of money destruction from this event. This money would have arrived through the check clearing process. Clearly we could buy bank share with it, we could also begin a bank with the same money (as a reasonable alternative use). When a bank receives money from the sale of shares, it increases the ability of the bank to post reserves. The bank should post an increase in available reserves, an increase in the number of shares outstanding, an increase in paid-in-equity and an increase in liability deposits owned by the bank itself (contrasted with liabilities owned by depositing customers).

I agree that the original loan remains valid at this point.

Would it help to notice that if we assume that a bank creates money with every loan, we need to assume that the bank creates TWO assets? The loan and the deposit are each new assets.

As you say, the loan and deposit separate after the deposit is spent. Each enters into a unique life. The two come together again if the loan is paid off. If the loan is NOT paid off, the deposit continues to live.

At that point (loan failure) credits /= loans. This sets up a revisit as to why we think loans create money. Maybe loans do not create money. Or maybe we have two cases, each true during a time period where conditions fit the model. I tried to describe the two-case model in my previous very-long comment.

The problem that we must deal with is the case where credit does not equal loans. Do you still deny that this case ever occurs?

This is frustrating but I think very worth while. The mechanical links must all fit one-to-another to have a coherent fiat money model. Right? :-)

Johan (a couple of messages above): I don't understand this. You seem to define an overdraft limit in a way that suits your argument.

Say, Berkshire Hathaway (BRK) applied for an overdraft limit of $50,000,000 on its checking account at Wells Fargo's Omaha branch. Would the branch manager protest and set a limit at $10,000,000,000, just because he thinks BRK is good for that?

You cannot just assume that the overdraft limit is some kind of maximum. It isn't. In my example, the bank decreases the limit in full agreement with the customer, not one-sidedly. And the customer wants this to happen, because in this case he has particularly agreed to pay interest on the full limit (some real-life overdrafts are like this; some aren't).

If there was no interest paid on the full limit, and the customer wanted to keep it open, then the full limit would probably remain intact all along -- it would clearly not be increased to $500,000. Sure, the bank would have more evidence of the creditworthiness of the customer, and might be willing to extend the limit somewhat. But everything above the market value of the house would be un-collateralized credit. (As I said, we didn't touch the credit contract of the mortgage, and it almost certainly included the house as collateral. We don't know the market value of the house, but it could have been expected to be well above $300,000 based on the information I gave. For all we know, the price could be even $1,000,000.)

Of course it suits my argument in that it's the way I interpret it (I built the argument around the interpretation). But it's also quite immaterial to the overall message in that the limit could also stay the same or be reduced. You need it to be reduced so that you have some anchor for attaching an interest payment and so that it could look like it's a direct equivalent to a "traditional" loan being gradually paid off.

I don't look at it that way: I don't see that you can sensibly equate the overdraft limit with the outstanding stock of mortgage debt. As I showed, the mortgage is being paid off in the overdraft version as well as in the two-account version using the same monthly increments. Only the order between paying on the loan and on living expenses is registering differently due to the necessary arithmetic involved. The overdraft version does not allow for discrete separation between salary paid and loan reduced whereas the two-account version does. That’s the source of the "discrepancy". The limit has nothing to do with it.

Antti… had a beer, waiting for the sauna to warm, and though about another thing regarding your example.

Now that the accounts are consolidated and there's a -245 000 (debit) balance outstanding, and, say, a monthly mortgage repayment (amortization + interest = 5 000) is still due that month. How would one go about paying such obligation if there's no salary incoming that month? There wouldn't be any such option available. In a two-account version you could do that simply by debiting the checking account with 5 000 and crediting the loan account with 5 000. In a funny way, considering the overdraft version, the *consolidation itself* did exactly that. So in a way, we could interpret the consolidation of the accounts as paying down a scheduled monthly mortgage obligation that particular month.

Roger: Sorry, your comment went to spam folder. Perhaps this happened because your approach is so mechanical that Blogger thought you must be a bot? ;-)

You said: "I find myself disagreeing at the thought of money destruction from this event. This money would have arrived through the check clearing process. Clearly we could buy bank share with it, we could also begin a bank with the same money (as a reasonable alternative use). When a bank receives money from the sale of shares, it increases the ability of the bank to post reserves."

You seem to jump from "bank money" to "central bank money" here. Which one you want to be the "money created"? I take the "customer deposit" to be the money created. And that kind of "deposits" are destroyed when a checking account customer subscribes to a share issue by his bank. DEBIT Checking account, CREDIT Equity. No "central bank money" is needed.

Johan: I still don't see your argument as valid. I'll try to keep this simple (so that you can continue to relax when you read this after the sauna!) by commenting only on the most clear-cut part of your two comments (if we get to agree on this, then we hopefully agree elsewhere, too):

You said: "Now that the accounts are consolidated and there's a -245 000 (debit) balance outstanding, and, say, a monthly mortgage repayment (amortization + interest = 5 000) is still due that month. How would one go about paying such obligation if there's no salary incoming that month? There wouldn't be any such option available. In a two-account version you could do that simply by debiting the checking account with 5 000 and crediting the loan account with 5 000."

The option you are missing is this:

Overdraft limit will be reduced by 5,000 minus interest. The interest will be debited on the checking account. The outcome is exactly the same as in the case of two accounts, isn't it? If interest charge was 500, then overdraft limit would be 245,500 and the checking account balance would be debit 245,500. This compares with loan account balance of debit 245,500 and checking account balance of zero.

(In your example, the bank wouldn't credit the loan account with 5,000, but with 5,000 minus interest. Interest would be credited to an income account of the bank.)

What the limit has to do with this is that it is comparable to the balance on the loan account. Have you considered a (hypothetical) case where the loan is not amortized, but the bank has agreed to pay interest equivalent to the interest rate on the "loan" on the customer's checking account balance? (This doesn't give rise to an arbitrage opportunity, and the bank still profits on the net liability of the customer.)

Doesn't that make the "two account version" more comparable with your idea of an overdraft? And doesn't the balance on the loan account in that case look very much like the overdraft limit?

Yes, true, good spotting, I missed the interest in the last example. In your version the limit must symbolize the balance of the loan account. But the fact remains than you could do adjust the limit however you wish (but not put the customer arbitrarily into default)… and the mortgage would still be paid on the same monthly schedule as in a two-account model. Thus, the "discrepancy" appears to be self-inflicted by choice.

I have no problem with the overdraft limit looking like the balance on the loan account. What I don't see is why, even in principle, it could be confused with a repayment/redemption of the loan?

I see what you mean. In the scenario you built the "monthly picture" is the same in both two-accounts version and an overdraft. Right?

If the loan was amortized in the end of the month and the salary was credited on the account in the start of the month, then there would be almost one month between debt-repayment in overdraft case vs. (alleged) debt-repayment in the case of two accounts.

But we could easily build cases where the (time) discrepancy is a lot larger. Like building a larger "nest egg" on checking account while continuing with slow pace of loan amortization.

I also think that one interesting aspect in this is the mental effect of having a checking account with a large negative balance. One would be reminded every day that one is deeply in debt. As things stand, some people with mortgages barely consider themselves to be indebted :-)

the differences found between the accounting versions could also be attributed to differences in sequentially traceable information content; i.e., it seems more difficult to follow "relative intra-account" balances. Instead, there's only the submerged status of the overall balance, which, from another angle could be views as a positive. It's a matter of preference whether one considers the view of an overall balance as more useful than a detailed one.

From a (real-world) legal point of view it would be difficult to actually combine such overall balance into a single checking account. That has to do with common law notions pertaining to the banker's right to offset and lien. Normally banks have the right to combine accounts (offset) in situations where one account is in overdraft past due and the other has a credit balance, say a savings account or another checking account with the same bank. Common law does not, however, recognize the right to offset in situations where the other account is a loan account, as in a mortgage loan account. Should the mortgage debt repayment be past due, there's still the possibility for the bank to claim something to the effect of an offset by debiting a checking account if in credit, but not as an ongoing practice by simply merging the accounts. For such circumstances banks (usually) already have the recourse to use the property underlying the mortgage as a lien – a defensive right – which it may exercise and force the property to be sold during a default resolution procedure. The bank cannot, obviously, use a customer's deposits or the overdraft limit as lien. This is probably why we don't have consolidated mortgage-checking accounts and why overdraft accounts tend to be used within a checking-account context/function only.